Coping with Poor Corporate Hygiene in the Early Stage (Part II)

Last week, Dan Mahoney and Jim Thorton discussed the costs of "poor corporate hygiene" in early stage companies to include the overzealous use of options (and how it affects the cap table), as well as the pitfalls of short-sighted legal structuring. The lack of attention to these issues can often render an early stage company unfundable in the next round. This week, Dan and Jim discuss the potential benefits, but more important the likely costs, of short-sighted corporate partnering, bad licensing and how ineffective boards can negatively impact early stage companies.

Costs of Corporate Partnering

Most business plans presented to VC's include a business model that is devoid of any corporate partnering strategy or fails to account for the time required to find and close a validating corporate partnering deal. While a corporate partnering strategy is not a prerequisite for a successful portfolio company, a partnership that reduces or shifts marketing, financial and regulatory risk can be a validating component of any business model. Moreover, a corporate partnership provides a startup with access to valuable licensing networks, management expertise, and enhanced access to additional capital and markets.

A recent startup presented a compelling investment opportunity. However, the startup was in the process of negotiating a partnership with an established pharmaceutical company on terms that were unacceptable to the new VC. The arrangement would provide the pharmaceutical company with access to the startup's new drug discovery tool. Unfortunately, the startup was denied an opportunity to realize any upside participation in the pharmaceutical company's identification of new drug compounds that might result from the use of the tool. The founder's had simply been too unfamiliar with the acceptable methods of partnership in the life sciences area. On the advice and with the support of its new VC partner, the startup was able to convince the pharmaceutical company to provide a royalty arrangement with respect to any new drug-related discoveries that resulted from the startup's tool. Fortunately, the technology and innovation behind the tool was a compelling reason for the pharmaceutical company to accede to this arrangement.

While a well-structured corporate partnering strategy is a valuable element of a successful portfolio company, it is not without its concerns. The startup mentioned above was so enamored with the thought of partnering with a well-known pharmaceutical company that it simply overlooked some important consequences. The contract presented by the pharmaceutical company did not contemplate the potential imposition of various legal constructs, such as the "corporate opportunity" doctrine, fiduciary duties, and obligations of "good faith" and "fair dealing." These nebulous concepts often require each partner to show the other any related opportunities that come to its attention, to act in a measured manner toward the other party, and to assess the liability exposure of competing with the other party, even in a seemingly unrelated endeavor. While these would generally be of greater concern to the established pharmaceutical company at the outset, they could ultimately adversely affect the startup.

These issues can be governed by contract, but often they are simply ignored. Whether as a result of deference to the larger partner or the reckless pursuit of a promising new partnership in a capital-scarce environment, there is generally a failure to contemplate negative scenarios and contractually provide for remedies. The result is the application of a poorly defined default standard that may vary between jurisdictions. Adding to this complexity are issues posed by cross border partnering arrangements, namely, choice of law issues, where one partner is domiciled in the United States and one overseas. This issue takes on added complexity with the existence of competing rules governing the ownership and administration of intellectual property.

As part of its renegotiation of the contract and attainment of the royalty arrangement, the startup and the pharmaceutical company revised the joint development agreement to specifically provide for the following: curtailed and well-defined fiduciary obligations to each other; the absence of the corporate opportunity doctrine or any obligation to share opportunities that arise; an established set of physical and conceptual parameters outside of which the parties were free to compete with each other; specific obligations and the degree of effort that was expected of each party; and well-defined ownership of jointly-developed intellectual property.

Portfolio companies should also be expected to contemplate a divorce of any strategic partnership. Where intellectual property is involved, this issue takes on paramount importance. To illustrate, a fabless semiconductor startup had entered into a joint development agreement with a large manufacturer of semiconductor devices. Again, having been captivated with the prospect of partnering with a "big name" in the industry so early in its corporate development, the startup entered into the agreement quickly based upon questionable advice from its general legal practitioner. The founders failed to contemplate ownership of intellectual property enhancements, improvements, and significant modifications, as well as who would prosecute patent claims on jointly developed intellectual property in a post-divorce scenario. The result was an agreement that significantly favored the large corporate partner if the deal went "sideways."

Because the partnership also provided the startup with a license to use certain technology that was instrumental in achieving its next few milestones, the VC was unable to overlook or ask the startup to terminate the relationship. The alternative solution was a renegotiation of the agreement with the support and guidance of the VC that resulted in a more well-defined and acceptable joint ownership arrangement post-divorce.

Specifically, the parties would maintain joint ownership of any intellectual property developed under the agreement but the corporate partner would be responsible for prosecuting and maintaining patent claims and the related expense. However, the startup retained the right to participate in the prosecution of any patent claims. Finally, the corporate partner was responsible for protecting the intellectual property against infringement by third parties and taking all steps reasonably requested by the startup to do so. In exchange, the corporate partner was provided an opportunity to participate alongside the VC in the financing and also received common stockwarrants as an incentive.

Poorly Negotiated Licensing Arrangements

Poorly negotiated licensing arrangements jeopardize the validity of a portfolio company's business model. Some examples to watch for are failures to anticipate likely liquidity events, the surrender of patent prosecution and strategy to a large corporate partner, or provisions that rest approval of reseller channels or trade discount amounts solely in the hands of licensors.

One familiar example involved a medical device startup with an impressive in-licensed patent portfolio. Some of the licensed technology was actually a sublicense from a large device company that was itself licensing the technology from a major University. The first problem that the VC confronted was that the startup relied heavily upon the sublicensed technology. Unfortunately, the license arrangement rendered the startup overly dependent on the device company as licensor. For instance, the startup was unable to license derivative discoveries directly from the University for a new application. In addition, if the underlying license was terminated between the University and the device company the startup's sublicense was automatically terminated without any assurance that the University would agree to license the technology directly to the startup.

The startup's management was properly mentored on the deficiencies of this arrangement, after which they approached the device company and the University's representative with a request to renegotiate, or at least supplement the license arrangement. The startup was able to acquire certain rights that allowed it to ease its reliance on the device company as licensor. Most notably, the startup obtained the right, upon a termination of the master license, to step into the device company's position as primary licensee with no future obligation to the device company. Fortunately, this was accomplished without an issuance of warrants or other expensive concessions.

The most difficult hurdle the startup and the VC faced, however, was the result of an ambiguous assignment clause in another license agreement. This clause could arguably be read to require consent from the licensor in a transaction involving the sale of the company, even if the company itself remained intact. Eventually, the startup received an offer from a publicly held device manufacturer to acquire all of the assets of the company, including the assignment of the license rights. As the startup proceeded to explore the opportunity and conducted some internal due diligence, it discovered that the potential acquiror had competed with this particular licensor. An initial discussion with the licensor confirmed that an impasse had been reached since the licensor was reluctant to consent to the assignment of the license and let the "fox in the henhouse."

Company counsel determined that the assignment clause in the license was flexible enough to attempt an end around through a structure called a reverse triangular merger. This would entail having the acquiror create a wholly owned subsidiary and subsequently merge the new entity into the startup. This would result in the startup's shareholders receiving stock of the acquiror in exchange for their shares in the startup and the startup would become a wholly owned subsidiary of the acquiror. Because the startup would not actually be merging into another company or assigning the rights to another entity, the consent of the licensor was technically unnecessary.

However, as anticipated, the acquiror rejected this proposal for two reasons. First, as is typical in a transaction involving the acquisition of a private company by a public company, the acquiror wished to avoid assuming any liabilities of the target, even if confined to a subsidiary. A purchase of assets would allow the acquiror to pick and choose which assets and liabilities it was willing to accept and those that it would leave behind. A merger would require the acquiror to assume all of the startup's liabilities. Second, the acquiror was concerned that the licensor would challenge the transaction as a de facto assignment without its consent and a breach of the license. Ultimately, if the transaction were going to proceed it would be a sale of the assets and an assignment of the license rights, requiring the consent of the reluctant licensor.

An alternative was discussed. With the help of its existing VCs, the startup was able to locate alternative technology. However, the price of acquiring or even licensing the alternative technology was exorbitant and was likely to sink the proposed offer. In the end, the startup and the acquiror made an expensive concession to the licensor in exchange for its consent. The licensor received an additional license fee and royalties of 8% on the net income earned from the sale of products derived from the license. Additionally, the acquiror's right to use the license was narrowly defined and significantly curtailed from what the startup had originally been granted. As a result, a portion of the purchase price was deferred as earn-out payments to the two founders over an extended period of time. Any royalty payments received by the licensor were deducted directly from the earn-out payments.

Ineffective Boards

VCs often experience a difficult set of decisions regarding board composition in early financings. Unfortunately, they typically defer these decisions out of a fear of having a deal "blow up" or the risk of being perceived by the entrepreneurs as "taking control" of the board.

One recent early stage company illustrates the dangers of an ineffective board. The founder had assembled a board of cronies who quickly extracted an inordinate number of options for themselves. Unfortunately, their advisory capacity was not commensurate with their compensation. These "mentors" spent very little quality time with the company, possessed no rolodex for recruiting or partnering, and had little understanding of the technology, the industry or its direction. The result was a "rubber stamping" of CEO recommendations and minimal scrutiny of company practices and results.

Despite its meager board of directors, the company's wireless technology was quite impressive and the founder's penchant for innovation was extraordinary. In its first round of institutional financing, the company actually courted a handful of top tier venture firms with two of the VCs ultimately co-leading the round. The VCs were equally excited about the prospects for the company but each wore scars from experiences with other companies possessing entrenched and ineffective boards. VCs usually interpret entrenched boards as a signal that the company is disdainful of objective outside representation and is seeking capital with a modicum of "interference" from the investors. However, the VCs knew in this case that the founder was unsophisticated in the area of corporate governance and that the existing board was not representative of the founder's expectations. In any event, funding would be contingent upon an overhaul of the company's advisors.

The result was a redesigned board. The number of directors was capped at five. Each of the VCs was given one board seat to provide experience and insight, as well as strategic direction. Two of the board seats would be filled by industry experts to be identified within two months of the financing with the assistance of the VCs. The final board seat would be filled by the company's founder but would replaced within six months by a new CEO possessing industry knowledge and experience at the helm of an emerging company.

Conclusion

Corporate hygiene is an important barometer for VC's to consult when assessing the health of their portfolio. Concealed deficiencies or other "warts" often exhibited by startups do not have to be "deal killers" if they are identified early by the VC working closely with competent and enlightened advisors.

Dan Mahoney is an attorney with the Phoenix office of Snell & Wilmer LLP. His practice is concentrated in business and finance, with a focus in securities, venture capital, mergers and acquisitions and corporate compliance. Mr. Mahoney regularly works with clients ranging from small start-ups and emerging growth businesses to large publicly held corporations. He can be contacted at 602-382-6384 or dmahoney@swlaw.com.

Jim Thornton, co-founder and Managing Director at Guide Ventures, is focused upon early stage investing within the Information Technology and Life Sciences sectors for the Western United States. He concentrates on operational issues within startups as well as actively assisting entrepreneurs in team building and strategic partnering. A member of the board for Bocada Corporation and Biopsy Sciences, Jim can be reached at 520-577-0954 or jim@guideventures.com.